Posts Tagged stock market

For years now, market participants have been arguing on whether or not “the” market top has been seen. So far, those who had suggested “a” market top yes, but not “the” market top have won the argument and prevailed. That being said, “this time”, both economically and market wise, it appears likely that we are in the later stages of a growth and bull cycle.

This conclusion may be easier to reach compared to the timing of a correction that could follow it. I am watching multiple “big money” sources, and all I see is a wide spread agreement on a tiring up trend, but hugely different projected time lines of a reversal.

Well then, what do we do now?

The Sun is Gone

Since 2008 global financial crisis, central bank balance sheets have grown from 3-5 trillion dollars to 15-20 trillion, China included. This 12-15 trillion created out of thin air did pull the global economy out of a deep hole and some but, has also created a dependency on easy money.

In short, FED driven expansion days are over. We all need to tattoo this on our chests backwards so we can read it in the mirror as a reminder every morning…and drop our habits developed in the last 9 years relying on it. Party bowl is gone and it’s time to sober up.

The direct effect of easy money policies has been stretched valuations in most asset classes. You can see this in your stock portfolios, real estate and speculative investments.

The good news is, that the global economy is still growing, valuations came down a bit from highs due to the drop in Feb-March of this year and forward earnings are closer to historical averages. Plus, just because the monetary easing has stopped and tightening has been resumed, it doesn’t mean liquidity has dried up. There is still plenty of cash hovering around globally.

You might ask: How much longer can the economies grow, and what if forward earnings disappoint?

The answers are: Probably not for much longer, and a correction would only be natural.

But I Have a Light

Yes, the FED sun is gone, but there is still plenty of light. The global growth is in tact and a recession isn’t an evident threat in the short term. Pro-growth policies are gaining traction, interest rates are still low, consumer and business confidence are high. On the cons side, populist rhetoric and policies, trade wars and anti-immigrant sentiment raise political risks, which can override the positives rapidly.

Just when the volatility has risen, inflation is looming, currency fluctuations are hurting trade, oil price is up and FED is in a tightening mode, the last thing markets need is irresponsible and short sighted political outbursts.

Had I just focused on newspaper headlines, I would say liquidate all your holdings and start planting tomatoes cause a third world war is looming. Luckily, there are plenty of reliable indicators suggesting that things are not that bad.

Here is a critical question in that regard: which single data point has the highest probability of predicting a recession in the US? Like any other question in finance, you’ll get many different answers to this but I agree with Ray Dalio, the manager of the largest hedge fun in the world, Bridgewater. He argues that the debt service ratio is the most important single data point as we live in a debt driven consumer economy. The end of a growth cycle usually comes with a debt service ratio high enough to hurt consumption. In other words, once the interest payment on the loan starts hurting new purchases, that’s when the party ends. Business cycles and equity markets are driven by this phenomenon. Without further ado, let me share with you that current debt service ratio in the US is at all-time lows, consumer balance sheets are healthy and household net-worth is at all-time highs.

What’s the Game Plan?

It’s a military rule, that strategic mistakes can not be remedied by tactical moves. Meaning, if you have your longer-term objectives, plans and action items lined up ineffectively, short term shifts can not bring ultimate success. So, first lesson from this is to make sure that you, or your financial advisor, wealth manager, financial planner etc…understand your long-term goals and your portfolios are adjusted accordingly.

The key thing here is to focus on asset classes more carefully then securities within in it, because 70% of a portfolio’s returns come from asset allocation decisions.

Once your asset allocation (stock, bonds, cash, alternatives) fits your long term strategic goals, then in the next 12-18 months, each time you see a high in the stock market, consider using that as an opportunity to lower your risk exposure from stocks to bonds, from international to domestic equity, from cyclicals to non-cyclicals.

As far as the timing goes, it is close to impossible to know when the bear will attack, but it’s probably fair to say that sometime within the next year or 2020. We may see a seasonal summer weakness ahead, higher volatility approaching the mid term elections, and a recovery during the seasonal Santa Claus rally.

But looking at the correction in 2015, let’s remember that the recovery at year end was reversed during the following January in 2016. This time around, that reversal to the downside has the potential to has a longer duration. To be fair though, the worst year in a 4-year presidential cycle is the current second year and the best year is the third, which will be next year in 2019, so there is still some things to be hopeful about.

The Key Factor

I was working at a bank during the Nasdaq bubble and at a money management firm during the Global Financial Crisis in 2008. In both cases what I have observed is, that from trough to peak, a buy and hold equity portfolio recovered its losses 5 and 4 years respectively (based on S&P 500 returns). For a risk adjusted, diversified and rebalanced portfolio, that time span was halved.

More importantly, those who got out at the wrong time, missed the fast run up following the drop. So, in other words, your stocks, bonds, cash and alternatives asset allocation, shouldn’t force you to sell at the worst possible time.

In fact, those are the times, in hindsight, appear to be the best times to start buying. The key is to be able to stay invested for the long term.

Summary

A peak in the economy and equity markets might be near. Timing the reversal of the uptrend is extremely difficult, if not impossible. So in the next year or so, you might want to consider lowering your risk levels during up swings to a level that will not force you to sell during the correction

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

“Whatever has the nature of arising, has the nature of ceasing.” – The Buddha

First thing first: I hope you had a wonderful Thanksgiving with your family and loved ones, and wish you a great Holiday Season, Christmas, News Year….under whatever name, shape or form you enjoy celebrating. My usual attitude I have adopted from a longtime friend is: “Is there something to celebrate? What are we waiting for?”

If you have read my previous newsletter, you might recall the above quotation and might be wondering if I have forgotten something. No, I haven’t. When I sat down to produce this quarter’s letter, I realized that I couldn’t have found a better quote, so I kept it.

As we’re approaching a new year, following a period of strong performance, many of you are probably nervous or wondering if a deep correction is due. Common questions are: Is this time to sell? Is there more room for growth? Should I invest now or wait for a downturn?

For those looking for quick answers: not yet; probably yes; and what about dollar cost averaging?

It all depends on your goals, time horizon and risk appetite. To demystify my answer, let’s dive in.

Cry Wolf

The current market regime we are in might be best described as the “most hated bull market in history.” For years, many participants have been calling for a correction and yet here we are, with solid returns.

I can not tell you how many client meetings I have had since 2011, making a bullish case, settling a client’s nerves, who had just read a report suggesting that huge losses were ahead.

There is actual research showing that some republican leaning investors had missed out on the “Obama rally”. It looks like now it is the democratic and liberal leaning investors’ turn to sit on the sidelines and watch the market that they so “hate”, to run up.

Looking at valuations and extreme optimism, is this “the” time to go out and save the shepherd from the wolves? If we do so, will we look like fools, again? There is a third way.

Don’t Throw the Baby Out with the Bathwater

There is plenty of research that shows that the majority of portfolio returns come from asset allocation decisions. In other words, whether or not you will be invested in stocks, bonds, alternatives or stay in cash, is the most important decision. The effect of security selection, is miniscule compared to this very fundamental decision.

That being said, like most things, it is not black and white. You should make buy all, or sell all decisions. Better said, fine tune your asset allocation, to fit the current investment regime.

We are not bound to decide whether to fully get out of the market, or blindly stay in it. Instead, we need to keep our eyes on current market drivers, pay close attention to our time horizon and investment goals, and make adjustments accordingly.

Current Market Drivers

I am fortunate to serve many clients who are smarter and better educated than myself. One of them once told me “I don’t get what you’re doing, it seems so complex.” Coming from a man with a PhD in computer science, I was humbled, but to tell you the truth, it isn’t all that complex, it all boils down to:

Markets go up because there are more buyers than sellers.

Economies grow because more money is spent this year than last.

So, the two most important components are: 1 – How much money is out there? 2 – What is the investor/consumer sentiment? In short, it’s all about the FED and psychology.

How about valuations? Research shows that valuations are better indicators for long term (5-10 year) returns, but have a terrible record for shorter term (1-3 year).

The FED, crowd psychology, the economy and politics are undoubtedly interrelated but the end-result on investments has to be separately and carefully analyzed.

We still have a friendly FED, an overly optimistic crowd, a strengthening economy and a market friendly tax bill on its way.

Not too shabby, however the key word here is “overly”. In spite of Keynes’ famous quote “Markets can stay irrational longer than you can stay solvent.” overly optimistic sentiment usually gets punished shortly after.

So…2018?

If you think I am giving mixed messages, that’s because I am. On one hand, I know that when the FED is friendly, the crowd is optimistic, the economy is strong and politicians are market friendly, fighting against this picture is foolish.

On the other hand, looking at historically high valuations, very little cash sitting on the sidelines, and extreme investor optimism, this might be the time to give the shepherd who cried wolf, the benefit of the doubt.

Action Items

How to reconcile these two sentiments?

Clarify the purpose of your investment. If you have a long-term goal, short term fluctuations shouldn’t scare you away from investing, but if you may need these funds within a year, this might not be the best time to get in.

Brace yourself for volatility. 2018 probably has one or two 5-10% pull back(s) built in to it. So, consider how to lower stock exposure, raise cash, or prepare yourself to ride the roller coaster, and have a 10% drop in US stocks as one of your what if scenarios.

Make sure you’re diversified. Usually, what went up the most, comes down the fastest. In the current case, it is the tech stocks. Make sure your tech stock exposure is in line with your risk appetite.

Have some international exposure. While the US FED is raising rates, European and Japanese central banks are still in their easing mode, most likely till the end of 2018. These countries, along with Emerging Markets may offer better value.

If you’re overly concentrated in any particular security, look for strategies such as put options.

Don’t be afraid of raising cash.

Watch for earnings because the market is priced for perfection and a negative surprise could be the black swan in the lake.

In Short

2018 will likely end up being a positive year, but returns may be muted and may come with volatility. So adjust your strategy accordingly.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

Many observers are surprised with the current levels of US Stock Indices. There is so much talk about stretched valuations, Trump Trade being over, the potential damage of rising interest rates, trade/currency wars, political uncertainty, rising inflation and last but not the least, the aging economic growth cycle, that given all this, stock prices seem unjustified.

Looking at this wall of worry, one might conclude that “the winter is coming” and it’s time to run to the hills away from the White Walkers, short sellers and bearish bets.

In the past, I have seen how Republican leaning investors, commentators and strategists have allowed their political views to cloud their judgement, and how this led to misguided conclusions, most of which, have been proven wrong.

Unlike the popular rhetoric, the stock market rallied during Obama years, the dollar got stronger, inflation has been tamed, unemployment dropped like a rock, the economy grew and the US has become the safe house in a shady neighborhood.

The thorns of this rosy picture have been stagnant incomes, and stubbornly elevated public debt.

Learning from this experience, investors need to set aside their political views and think with facts in hand, not allowing their preconceived notions to get in the way.

I will address these concerns, and conclude that the stock market still has room to grow, pullbacks are likely and they should be used as buying opportunities.

Concern 1: Stretched Valuations

No matter how you slice and dice it, stocks are expensive. Questions to follow:

1 – How expensive?

2 – Can they go higher from here?

They are extremely expensive when you just look at absolute, traditional, isolated price to earnings ratios. If this is your only gauge, the answer to the second question is a short “no”, and they can’t get go much higher from here.

But when you look at relative factors, especially when compared to other investment vehicles like bonds, real estate, commodities and currencies, stocks still seem to provide growth potential. Roughly a third of US domestic stocks’ dividend payout rate is higher than the yield on 10 Year US Treasury.

In other words, when compared to especially low bond interest rates, stocks are only moderately expensive and the answer to the second question in hand is a “yes”, they can still go higher.

Also, from a purely investment strategy point of view, all we really care about is the asset price action and when we dive in to it, we get good and bad news.

The bad news is that high valuation is a pretty reliable indicator of investment returns in the following 10 years. The good news is that the same cannot be said about the following 3 years. So, if history is any guide, one can conclude that the investment strategy could be to ride the wave while it lasts, especially in the next 3 years but moot your expectations for the next 10 year returns.

Concern 2: Aging Economic Expansion and Bull Market

We are in the eighth year of a stock bull market and economic growth. On average, economic expansions last about 5-7 years and the longest has been 10 years (1992-2002). The stock market not only hasn’t seen a bear market since 2008, it also hasn’t seen a 10% correction for 287 market days as of 4/1/17. So justifiably, some argue we may be approaching a rest stop with a horrible vista point.

I will counter this argument and hope to offer some consolation with 3 supplemental sets of facts.

1 – First let’s get the 287 market days without a 10% pull back, out of the way. Assuming we are in a long-term bull cycle, this is well within historical averages.

2 – The US stock market hasn’t seen bear claws since 2008, but came pretty close with a 15% correction (Q2 2015 – Q1 2016). During the same period, global stock market did face the bear with many developed economies’ losses of well over 30%.

3 – If we expand the above-mentioned period to Q1 2014 – Q1 2016, we’ll see a stock market that was flat for two years (consolidation). Such periods can and do act like a bear market, especially when they last for two years.

On the topic of economic expansion, the key thing to remember is that in spite of its duration, the growth level is still well below past recoveries, and current indicators do not waive the checkered flag for the stop pit.

Concern 3: Rising Interest Rates

It is true that stocks struggle during rising interest rate environments. The reasons for that are plenty but the usual suspects are: 1 – Increasing cost of money, makes it costlier to do business and invest; 2 – Some fixed income securities’ yields start to look attractive compared to risk adjusted equity returns.

That being said, current levels are low enough to give us some time before the danger zone. If you’d like me to be more specific, the 10 Year Treasury Yield is at approximately 2.5% and historical tendencies point to a 4% rate as the line in the sand in the tug of war. Based on FED actions, it may take us till the end of 2018 or into 2019 to reach that point. Since I try not to make predictions that far in advance, knowing what I know now is good enough to conclude that the current rising rate environment may not hinder equity returns.

Concern 4: Political Uncertainty

Markets have welcomed Trump’s presidential victory as they saw four arrows in his quiver:

1 – Tax cuts

2 – Lower regulations

3 – Fiscal expansion

4 – Trade wars.

Except for trade wars, the rest are deemed to be business friendly and hence will boost earnings. Well, this is a typical case of confirmation bias at least from the earnings point of view. As of 3/31/17, S&P 500 Operating Earnings Per Share has gone up 22.1% (Source: S&P Dow Jones Indices).

In other words, the earnings environment is the best in years and this is due to the pre-Trump economic environment, finally acknowledged by Republican leaning market participants, who for years have advocated a recession. (Sorry to sound speculative and like a sour cherry here.)

I welcome this development as it not only reflects domestic facts more accurately, but also global positive economic surprises.

For those curious minds, the biggest jump came in materials and technology sectors, 36% and 32% respectively, while the biggest loser was real estate by -32%.

In other words, given that a simpler tax code is better for business and the economy, smart deregulation can translate in to a more robust business environment and fiscal expansion is past due because of the FED’s inability to stimulate, setting politics aside, current stock levels may be justified.

Summary

For those readers who look for the blue or the red pill type of conclusion from all this, here is your takeaway:

Yes, the market seems moderately stretched

Therefore, a correction may be around the corner

“Sell in May, Go Away” strategy may prove prudent this year as we approach seasonally weak summer months

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

“Life is pleasant. Death is peaceful. It is the transition that is troublesome.” Isaac Asimov

A client and friend asked why the current US stock market was having a hard time finding a path and if I saw this lack of a path as a threat to the global financial stability.

I started my reply with “In short…”, only to realize I had promised in my last newsletter, to share reasons to be bearish in my next newsletter and Eureka! Without further adieu: “6 reasons why US stock markets are having difficulty forming an uptrend.”

Reason 1: Transitionfrom the Industrial Revolution to Information Age

We are at a juncture where multiple trends are ending and are in transition to the next. The biggest one of these is the end of the Industrial Revolution, which started in the late 1800s in England and probably lasted until the end of the 20th century. I use caution here as trends and cycles are difficult if not impossible to define while in them. Most of the political and economic concepts we live in or with, were either born or have grown strength as a result of this mega step in human history. The world’s governmental and economic systems are built to support this industrial life style based on production, transportation and consumption of goods, while supported by the banking system whose function is to turn profits into investments for businesses and lending for consumers.

And then, there came the technological revolution and globalization. In this new world, information and ideas may have become more important than having access to capital, as money is easily and readily available to invest in marketable ideas. Labor markets are global and therefore more competitive. National borders are less meaningful, as resources move faster than ever. Education systems, at least here in the US, fail to prepare the youth for the skills needed in this new economy. Automation is taking over human participation in production. Productivity growth no longer equals income growth. Since 1970’s incomes haven’t been able to keep up with productivity growth and the gap has been widening (except in the last few years because of falling productivity). With the use of computerized trading systems and financial engineering, risks and returns have grown exponentially. The level of welfare and the income distribution policies are a discussion for a heated debate, as haves can reach resources globally, while have nots end up competing against poorer parts of the world who are willing to work for much less.

As a result of this mega shift, there are 5.5 million job openings in the U.S. that can’t be filled, which was 3.5 million only two years ago. The capital markets and investors are trying to adapt to this new wave of technologies, business models and get a better sense of the present and projected valuations, while seeking balance in risk/return relationships. This tug of war between the past and the future is forcing the global economic machine and its capital markets to give errors in the forms of global financial crisis, massive computerized trading errors, discrepancies in valuations and increased volatility. Are these new challenges? No. But their magnitude brings us to an uncharted territory and at times, the capital markets act like a deer in the headlights. This long period with a sideway trend we have been in since November, could be one example.

Reason 2: Global Economic Slowdown

Are we in a global economic recession? No. According to the Organization of Economic Co-operation and Development (OECD), there have been 13 global downturns since 1960, last one being in 2011, with average length of 22 months. It looks like every 4-7 years, we go through a global recession and it wouldn’t be outside of historical averages if we experience a slowdown in the next 3 years. According to IMF calculations, global economic growth rate was 3.4% in 2014, estimated to be 3.5% in 2015 and 3.8% in 2016. So there is no global downturn currently or in the projected near future. However, it is not robust growth by any means and so it’s vulnerable to shocks. The strongest headwind for growth is the debt hangover. Governments and consumers are trying to pay down their debt as opposed to investing and spending, a minus effect on growth.

In most cases, when the US joins the international community and contributes to negative growth, markets react with a sharp decline. However, when the US is in growth mode while the rest of the world slows down, US stock markets typically go sideways. Given the problems in the EU zone and Japan, the slowdown in the Emerging Markets and US growth rate at around 2.5%, the sideway trend can at least partially be explained by the state of the global economy as a whole.

Reason 3: The Federal Reserve (FED)

We are in a central bank driven, multiple expansion based bull market. (Multiple expansion is paying a higher price for given earnings). Once the FED starts the tightening phase, we will be in a different zone and the US stock market’s reaction will depend on the speed of the rate increase.

Usually market tightening cycles start during an uptrend. Going back to all tightening cycles since 1946, the S&P continues the uptrend for another 4 months after the tightening begins (average of 5 cases). In the case of a fast tightening cycle though (7 cases) a sharp decline immediately starts with the tightening, lasts for 3 months to fully recover in 6

months (Source: NDR). So the speed of the hike is more relevant than the hike itself. Will the FED push rates up at a fast or slower pace? Most likely at a slower pace because the economy is growing at an annual rate of 2.3%, and the inflation rate that FED considers is at 1.8%. Slow growth, no inflation and lackluster income growth doesn’t give FED enough room to push the paddle to the metal. Even so, the markets are trying to adjust to the fact that probably the tightening cycle is only a few months away and as Isaac Asimov noted: “Transition is troublesome.”

Reason 4: Strong Dollar

It is usually a good sign when a currency strengthens. It shows that a country’s stability, the value given to its promises and its credibility are rising. It is however a headwind in the short term for the exporters as it makes the exported goods more expensive. About half of all revenues generated by the S&P 500 companies come from overseas. A strong dollar shrinks those revenues and makes it harder to increase market share. It is however also making imports cheaper, lowers input prices and so mutes the inflation. Since the US doesn’t have an inflation problem, the dollar strength isn’t helping. In time, a better and more efficient allocation of resources can and will usually fix this problem (which is good to have), but it does hurt growth while adjusting to it.

Reason 5: Low Energy Prices

Similar to a strengthening dollar, lower energy prices can be a good thing only if those savings were allocated efficiently elsewhere. The reason why it is a negative for now is that the energy companies are the largest contributors to capital expenditures (capex). Low oil prices mean low revenues for energy companies and low revenues mean low capex. Since one’s expense is another’s income, lower spending subtracts from growth. Also, their profit decline lowers their stock prices, adding more pressure to the market indexes.

Reason6: Stretched Valuations

Valuation is how much one pays to a security for expected returns (capital gains and income) at the risk level of that return to materialize.

Currently, the stock valuations are a bit stretched. Not so much that major indexes are in a bubble territory, but they certainly are not fairly or underpriced. One area that is in bubble territory is the dividend paying stocks. Those seeking yield have been discouraged by the bond market and have found refuge in dividend payers, which made that space a bit crowded.

The market is more vulnerable to shocks with stretched valuations. There is still upside potential…but the volatility in prices is harder to handle for many investors.

Summary:

The bottom line is that the bull market doesn’t end because it gets tired or it expires. It usually ends because of a recession, bubble type extreme valuations or extreme investor optimism. Currently, we are experiencing none of the above.

I have shared with you the reasons to be bullish and bearish in two market updates. Hope you have enjoyed – see you next time.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

“Reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium.” George Soros.

As we come close to the end of a volatile year in stocks, one sudden an unexpected development (for some surely it was expected) slowed down the pace of a typical Santa Claus rally, it caused a shallow pull back, and raised a lot of questions. Crude oil price’s sharp decline caught many investors off guard and the confusion increased volatility.

Meanwhile, the dollar’s rise is also raising eye brows and questions (this is especially entertaining as I remember reading and listening the experts arguing over a crash in dollar’s value during the years following 2009). These two macro level trends create their winners and losers, and their impact is so huge, I wanted to clear some of the confusion and discuss pros and cons of each of them.

Also in this market update, as promised, I will go back to the list of indicators outlined in the previous market update, to help us objectively monitor the direction of the markets.

I picked the above George Soros quote because more often than not, the stock market makes no sense, at least in the short term. Eventually, things settle down but markets can and do stay irrational longer than investors can remain solvent. The reaction to the oil and the dollar price movements is no different, confirming Soros’ conviction.

Oil

Let’s start with oil. Oil is a commodity, which means its price is determined by the global supply and demand, and once set, it’s the same price everywhere you go. So the crude prices fell because there is a glut of it, exceeding the demand. The US is now the largest oil producer along with the Saudis. Shale oil and fracking technologies opened up global reserves twice the size of crude. This is so significant that it’s worth a pause here: the world’s known crude oil reserves are 1.7 trillion barrels, while shale oil reserves are 3.3 trillion barrels, of which 2.6 trillion is in the US. In other words, the US has more shale oil than the rest of the world has crude! How about that?

On the demand front, the Chinese economic growth rate of 8-9% is starting to look like a thing of the past. The world is adjusting to a growth rate of 6-7% in China, which implies less demand for oil. Europe is also not doing so well, neither is Japan, so there is lower demand for oil. Also, here is something for those who would like me to be a more creative. Over the past couple of years, Putin’s Russia has grown to be a more bold, wealthy and aggressive country, not shying away from threatening Europeans of cutting off their natural gas. The drop in oil prices is an enormously effective economic sanction policy as Russia heavily relies on energy exports. So one can speculate: Is Putin being “put in his place”? Clearly, the Russian elite are shaken, which is the only force that can pose a threat to him.

So how do these developments affect you or your investments? Why is the stock market falling along with oil prices? Stocks are falling, because the market is confused and tending toward disequilibrium. The stock market is pricing the scenario in which the falling oil price is due to a slowing down world economy. Partially this is correct, but it doesn’t factor in the benefits of lower oil prices, such as more money in consumers’ pockets, lower input prices and inflation, lower interest rates and less pressure on the FED to increase rates. So in net, it is good for the US consumer, an economy which relies 70% on consumer expenditures. So it should be a good thing for the stocks, also right? Yes and once this is realized, it will be a tail wind for stocks.

Dollar

The US dollar’s uptrend can also be explained by the supply and demand to it. Everywhere you look whether it is China, Japan or Europe, you’ll find accommodating central banks opening their can of quantitative easing packages. They do this to stimulate economic growth, keep rates low, turn cash into thrash, escape deflation trap etc. Rings a bell? As the whole world is drinking the FED’s cool aid, FED is (finally) saying enough is enough. This divergence in central bank policies will raise interest rates in the US, make its securities more attractive, bring foreign investors and push the dollar up.

Just like falling oil prices, rising dollar is also a net gain event. Yes it makes exports more expensive and less competitive, but import prices go down, helps keep rates lower, taking the pressure off of the FED to increase rates, encourages bringing production back to the US, improving the consumers’ purchasing power. A stronger dollar by definition means relatively cheaper Euro, Yen and Yuan, which gives Europe, Japan and China a competitive advantage over the US in the global markets, hence the “currency wars” being back in the headlines. This advantage may translate into better performance overseas in 2015, which for diversified investors is welcome news as in 2014, international stocks have lagged significantly.

Naturally, these moves create winners and losers; for instance, companies that heavily rely on exports may find their margins squeezed, while energy stocks may feel the heat but overall, a net gain for the US consumer, is a net gain for the US economy and the investor. As for the losers, my biggest concern is a contagion created by troubled Russian banks and a banking crisis in Europe. For now, this is a low probability event, but almost all financial crises seem to be so, prior to becoming obvious.

Let’s now move on to the market watch indicators, but first refresh our memories, my select list is:

Since we have been discussing currency, interest rates and central banks, let’s follow the theme and take a look at FED’s policy.

The FED

March of 2015 will mark the end of the sixth year of the US equity bull market, which has been driven by FED’s policies. Now that the monthly bond buying program is officially over, can this tip the scale so much that bears get their day under the sun? I don’t think so. The US economy is growing moderately, the inflation rate is below the 2% target, and wage growth is still lagging and exposing the recovery’s Achilles’ heel. The FED doesn’t want to slow down the housing recovery, so while raising short term rates, it will aim keeping long term rates the same (flattening the yield curve), and keep mortgage rates low. In other words, just because FED has stopped the bond purchasing program, doesn’t mean it is out of the accommodating game all together, and if the last six years have thought us anything, it’s this ; DON’T FIGHT THE FED. So long as the FED is not tightening, which will be driven most likely by inflation rate peaking its head above the 2% target, its policies will be a positive for the market.

Economic Indicators and Demographics

To summarize, this can be said: the US economy is growing moderately and demographics are favorable. Today (12.23.14) third quarter 2014 gross domestic product growth rate came in at 5%, which is the fastest growth since the third quarter of 2003. So it is extremely difficult to argue in favor of a recession. As for demographics, the largest age group in the US is millennials, or generation Y; those born (roughly) between 1980 and 2000. The significance of this is that these folks are stepping in to their highest spending years in 2015 (please note that these figures are reported differently by different analysts, so there is some room for subjectivity here). The US economy will have a tailwind as a result of this for the next 15 years. Granted, some of the effects will be offset by the mega baby boomers retiring trend, but in net, this is a positive. So, two out of ten indicators are so far, favorable.

Let’s leave it here for now and pick up where we’ve left off in the next market letter. In it, I will also dust off my crystal ball and include 2015 projections.

I wish you all Happy Holidays and a great New Year.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

These trends are likely to continue in 2015, and so their effects…

“You know how advice is. You only want it if it agrees with what you wanted to do anyway.” John Steinback, Author (1902-1968)

Recently, I’ve got invited to a Rotary Club to share my thoughts on current economic and market conditions. I chose instead, a topic more interesting and not as dry for many, and talked about the findings of a relatively new field of study called Behavioral Finance. It is a hybrid of psychology and economics and aims to understand how people make financial and consumption decisions.

The main premise of this field is that we are not rational beings, and in fact quite predictably irrational. A good book on this topic is called “Predictably Irrational” by Dan Ariely. We are wired and conditioned to work really hard on avoiding cognitive dissonance, a mental state of stress when faced with conflicting information and a decision has to be made. So we’d rather look for information that supports our current opinions, pre-existing biases and choices, which behavioral finance calls “confirmation bias”. Having my thoughts around the topic, the opening quote by John Steinback caught my attention. I allowed myself to fall victim to confirmation bias and picked a quote on confirmation bias.

The bull market run in stocks, which started on March 2009 is now 5 years and 8 months old. Many call this the most hated bull market in history, and there is some truth to it. Usually investors love bull markets, this is when you see your investments grow, but why the hate?

The stock market correction and Global Financial Crisis that started in 2007 was so big, so deep and so wide spread, it wiped out many investors hard earned savings and/or cost them their jobs. From peak to trough, the S&P 500 index lost 56%, meaning if you had 100 dollars in Oct 2007, you had 44 left in March 2009. This trauma caused investors, both professional and individual, build such strong negative associations with the market, that they are having hard time adjusting to its 3 fold or 200% growth from the bottom.

From the get go, it was a lonely bull. During its first two months, a 50% knee jerk reaction jump caused many people to question its sustainability. A popular term at the time to describe it was “a sucker’s rally.”

Since then we had a dozen or so pull backs and corrections, and each time there were those who argued that this has been a rally stimulated by FED’s quantitative easing policy and a new bubble has been formed. Since we have just experienced what happens when we have a bubble in our hands, it is/was time to play it safe…and so goes the argument today just like yesterday.

The losses of 2007-2008 caused many to stay out of stocks all together or with less than usual allocation towards. This can be seen with striking numbers among millennials. Those who are between the ages of 14 and 34, are not interested in equity investing, in fact, investing in general. This lack of interest spills over to buying a home or a car and the popular trend among this age group is renting rather than ownership. They saw the consequences of being at the wrong place at the wrong time and they don’t want to fall victim to their parents’ mistakes. This attitude puts them in the spectator seat of a bull market that would have other-wise helped with growing their assets.

To be fair, the $1.2 trillion dollars of student loans hanging over their shoulders isn’t helping the situation, and of course there is always someone out there claiming fame after a pull back with a sign waiving “I told you so”.

At this juncture, approaching its 6th year anniversary, we need to answer whether we are close to the end of a short term bull market, or the beginnings of a long term bull. The difference between the two are the length and breadth (how wide spread) of the trend. The shorter term (cyclical) trends last somewhere around 3 to 5 years. Examples since the tech bubble burst are 2002-2007 bull followed by the 2007-2009 bear and 2009-present bull. The longer term (secular) markets last 10-15-20 years, like the 1982-2000 bull and 1966-1982 bear. Of course, there can and most likely will be cyclical bears and bulls within secular bears and bulls, only to last shorter, if they face against the longer trend.

If the bull market will prove to be a cyclical one, the end, by definition, can’t be too far in the distance. If however, we’re in the beginnings of a longer term trend, then even with 10-15-20 percent pullbacks and corrections, like the 2010 and 2011 16% and 19% corrections respectively, the bull can run for another decade or so.

The unfortunate reality is that we can only accurately know the answer to these types of questions after the fact. But that doesn’t preclude us from taking a calculated guess, and while doing so, we should always keep John Steinback in our minds and avoid confirmation bias.

Without looking for information confirming our hatred and death wish of this current uptrend, or our love and wishes of long and prosperous life, objectively how can we tell where we are right now?

We luckily have historical guidelines on our side to make and attempt to judge our coordinates. Here are some of the 10 indicators to watch:

1) Investor and trader sentiment

2) Valuations

3) Breadth

4) Cash ratios

5) Volatility index

6) Technical readings and seasonality

7) Economic indicators, demographics

8) FED Policy

9) Political risks, domestic and foreign

10) Interest and inflation rates

This list, of course can be broadened until cows come home but believe me, if you can make an objective analysis of these indicators, you will be ahead of many of your competitors.

When I look at these indicators, I see a mixed picture. In my next newsletter, I will get in to a deeper analysis of individual readings, but for now, this much I can say: stretched sentiment, valuations, cash ratios and technical, accompanied by high margin balances, are headwinds for the stock market.

This mixed picture, at least for now, is still in favor of a continuing bull market and a stronger argument for a secular trend. Once again, we can only have definitive answers in hind sight, but a 60/40 chance in favor of a secular trend versus a cyclical term makes more sense to me.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

In my next newsletter, I will elaborate more on this topic with more details on the above indicators.